Joseph mod Mankiw 20F Ch05 -...

10/5/2020

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Interactive PowerPoint Slides by: V. Andreea Chiritescu

Eastern Illinois University

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Elasticity andIts Application

CHAPTER

5

N. GREGORY MANKIW

PRINCIPLES OF

ECONOMICS

NINTH EDITION

© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Modified by Joseph Tao-yi Wang

• What is elasticity?

• What kinds of issues can elasticity help us understand?

• What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue and expenditure?

• What is the price elasticity of supply? How is it related to the supply curve?

• What are the income and cross-price elasticities of demand?

2

IN THIS CHAPTER


Our Scenario

• You maintain the social media accounts for local businesses – You charge NT$6,000 per business, and currently

maintain the social media accounts for 12 businesses per year.

• Your costs are rising (including the opportunity cost of your time).– You consider raising the price to NT$7,500.

• The law of demand: if you raise your price, you will not have as many accounts to maintain. – How many fewer accounts? – How much will your revenue fall, or might it

increase? 3© 2021 Cengage Learning

®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

The Elasticity of Demand

• Elasticity– Measure of the responsiveness of Qd or Qs

to a change in one of its determinants

• Price elasticity of demand– How much the quantity demanded of a

good responds to a change in the price of that good• Loosely speaking, it measures the price-

sensitivity of buyers’ demand

4© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

The Price Elasticity of Demand

5

Price elasticity of demand is

=

=

Along a D curve, P and Q move in opposite directions,which would make price elasticity negative.

We will drop the minus sign and report all price elasticities as positive numbers (absolute values).

P

Q

D

Q2

P2

P1

Q1

P rises by 10%

Q falls by 15%


15%

10%= 1.5

Percentage change in Qd

Percentage change in P

Standard method of computing the percentage (%) change:

Going from A to B:• the % change in P = 25%• the % change in Q = - 33%Price elasticity = 33/25 = 1.33

We get different values!

Calculating Percentage Changes

6

Going from B to A:

• % change in P = - 20%

• % change in Q = 50%

Price elasticity =50/20 = 2.5

P

Q

D

$7500

8

B

$6000

12

A

Demand for maintaining social media accounts


end value – start value

start valuex 100%

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The Price Elasticity of Demand

• Midpoint method– The midpoint is the number halfway

between the start and end values• The average of those values

• % change =

• Price elasticity of demand =


end value – start valuemidpoint

x 100%

Our Scenario: Calculating Percentage Changes

Using the midpoint method of computing % changes:

8

P

Q

D

$7500

8

B

$6000

12

A



$7,500 – $6,000$6,750

x 100%

= 22.2%

% change in P =

12 – 8

10x 100% = 40.0%% change in Q =

40/22.2 = 1.8Price elasticity of demand =

Active Learning 1: Calculate an Elasticity

Use the following information to calculate the price elasticity of demand for iPhone 12 Pro:

• if P = NT$35,900, Qd = 10,600

• if P = NT$52,400, Qd = 8,400

A. Use the midpoint method to calculate percentage change in price

B. Use the midpoint method to calculate percentage change in quantity

C. Calculate the price elasticity of demand

9© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a

license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

Active Learning 1: Answers

Using the midpoint method to calculate percentage changes:

A. % change in P =

[($52,400 - $35,900)/$44,150] ×100 = 37.37%

B. % change in Qd =

[(10,600 – 8,400)/9,500] ×100 = 23.16%

C. Price elasticity of demand =

= % change in Qd / % change in P

= 23.16/37.37 = 0.62



Determinants of Price Elasticity of Demand

We look at a series of examples comparing two common goods.

• In each example:– Suppose prices of both goods rise by 20%

– Which good has the highest price elasticity of demand? Why?

– What lesson we learn about the determinants of price elasticity of demand?



EXAMPLE 1: Samsung S20 vs. iPhone 12 Pro

• Prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

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• Samsung S20 has many close substitutes, so buyers can easily switch if the price rises

• iPhone 12 Pro has no close substitutes, so a price increase would not affect demand much

Price elasticity is higher when close substitutes are available.


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EXAMPLE 2: Mountain Dew vs. Soda (Pop)


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• For a narrowly defined good, Mountain Dew, there are many substitutes

• There are fewer substitutes available for broadly defined goods (soda / pop)

Price elasticity is higher for narrowly defined goods than for broadly defined ones.


EXAMPLE 3: Insulin vs. Rolex Watches


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• Insulin is a necessity to diabetics. A rise in price would cause little or no decrease in quantity demanded

• A Rolex watch is a luxury. If the price rises, some people will forego it.

Price elasticity is higher for luxuries than for necessities.


EXAMPLE 4: Gasoline, Short Run vs. Long Run

• The price of gasoline rises 20%. Does Qd

drop more in the short run or the long run? Why?

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• There’s not much people can do in the short run, other than ride the bus or carpool.

• In the long run, people can buy smaller cars or live closer to work.

Price elasticity is higher in the long run.


The Variety of Demand Curves – 1

• Demand is elastic– Price elasticity of demand > 1

• Demand is inelastic– Price elasticity of demand < 1

• Demand has unit elasticity– Price elasticity of demand = 1


The Variety of Demand Curves – 2

• Demand is perfectly inelastic– Price elasticity of demand = 0

– Demand curve is vertical

• Demand is perfectly elastic– Price elasticity of demand = infinity

– Demand curve is horizontal

• The flatter the demand curve– The greater the price elasticity of demand


Perfectly Inelastic Demand

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• D curve:

Vertical

• Consumers’ price sensitivity:

None

• Elasticity:

0

0%

10%= 0

Price elasticity of demand

=% change in Q

% change in P=

Q1

P1

DP

Q

P2

P falls by 10%

Q changes by 0%


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Inelastic Demand

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• D curve

relatively steep


relatively low

• Elasticity:

10%

10%> 1

Price elasticity of demand =

% change in Q

% change in P=

D

P

QQ1

P1

Q2

P2

Q rises more than 10%

P falls by 10%


Perfectly Elastic Demand

22

• D curve

horizontal


extreme

• Elasticity:

infinity

any %

0%= infinity

Price elasticity of demand =

% change in Q

% change in P=

D

P

Q

P1

Q1

P changes by 0%

Q changes by any %

Q2

P2 =


A Few Elasticities From the Real World



Eggs 0.1

Healthcare 0.2

Cigarettes 0.4

Rice 0.5

Housing 0.7

Beef 1.6

Peanut Butter 1.7

Restaurant meals 2.3

Mountain Dew 4.4

Joseph Tao-yi Wang

Selected Price Elasticity (from Wiki)

Rice[48]

-0.47 (Austria)

-0.80 (Bangladesh)

-0.80 (China)

-0.25 (Japan)

-0.55 (US)

2020/10/5 Elasticity

Eggs -0.1 (US: HH only),[54]

-0.35 (Canada),[55]

-0.55 (South Africa)[56]

Livestock -0.5 to -0.6

(Broiler Chickens)[44]

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Joseph Tao-yi Wang


Soft Drinks -0.8 to -1.0 (General)[51]

-3.8 (Coca-Cola)[52]

-4.4 (Mountain Dew)[52]

Cigarettes (US)[41]

-0.3 to -0.6 (General)

-0.6 to -0.7 (Youth)


Alcoholic Beverages (US)[42]

-0.3 or -0.7 to -0.9 as of 1972 (Beer)

-1.0 (Wine)

-1.5 (Spirits)

Joseph Tao-yi Wang


Transport -0.20 (Bus Travel US)[46]

-2.80 (Ford Compact Automobile)[50]


Airline Travel (US)[43]

-0.3 (First Class)

-0.9 (Discount)

-1.5 (Pleasure Travel)

Car Fuel[45]

-0.25 (Short Run)

-0.64 (Long Run)

Joseph Tao-yi Wang


Medicine (US) -0.31

(Medical Insurance)[46]

-.03 to -.06 (Pediatric Visits) [47]

Oil (World) -0.4


Cinema Visits (US) -0.87 (General)[46]

Live Performing Arts (Theater, etc.) -0.4 to -0.9 [49]

Steel -0.2 to -0.3[53]

Elasticity Along a Linear Demand Curve

28

The slope of a linear demand curve is constant, but its elasticity is not.

P

Q

$30

20

10

$00 20 40 60

200%40%

= 5.0E =

67%67%

= 1.0E =

40%200%

= 0.2E =


Our Scenario: Total Revenue

Continuing our scenario, if you raise your price from $6,000 to $7,500, would your revenue rise or fall?

Total Revenue (TR) = P x Q

• A price increase has two effects on revenue:– Higher revenue: because of the higher P

– Lower revenue: you maintain fewer accounts (lower Q)

• Which of these two effects is bigger? – It depends on the price elasticity of demand



Our Scenario: Elastic Demand

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Price elasticity of demand = 1.8

• If P = NT$6,000, Q = 12, and TR = NT$72,000

• If P = NT$7,500, Q = 8, and TR = $60,000

When D is elastic, a price increase causes revenue to fall.

P

Q

D

lost revenue due to lower Q

increased revenue due to higher P


$6000

12

$7500

8


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Our Scenario: Inelastic Demand

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Price elasticity of demand = 0.82

• If P = NT$6,000, Q = 12, TR = NT$72,000

• If P = NT$7,500, Q = 10, and TR= NT$75,000

When D is inelastic, a price increase causes revenue to rise.

P

Q

D

lost revenue due to lower Q

increased revenue due to higher P


$6000

12

$7500

10


Price Elasticity and Total Revenue

• For a price increase, if demand is elastic E > 1: % change in Q > % change in P

TR decreases: the fall in revenue from lower Q > the increase in revenue from higher P

• For a price increase, if demand is inelastic E < 1: % change in Q < % change in P

TR increases: the fall in revenue from lower Q < the increase in revenue from higher P


Active Learning 2: Elasticity and Total Revenue

A. Pharmacies raise the price of insulin by 10%.

– Does total expenditure on insulin rise or fall?

B. As a result of a fare war, the price of a luxury cruise falls 20%.

– Does luxury cruise companies’ total revenue rise or fall?



Active Learning 2: Answers, A

A. Pharmacies raise the price of insulin by 10%.

– Does total expenditure on insulin rises or falls?

34

• Expenditure = total revenue = P x Q

• Since demand for insulin is inelastic, Q will fall less than 10%, so expenditure rises.


Active Learning 2: Answers, B

B. As a result of a fare war, the price of a luxury cruise falls 20%.

– Does luxury cruise companies’ total revenue rises or falls?

35

• Revenue = P x Q

• The fall in P reduces revenue, but Q increases, which increases revenue. Which effect is bigger?

• Since demand is elastic, Q will increase more than 20%, so revenue rises.


Does Drug Interdiction Increase or Decrease Drug-Related Crime?

1. Increase the number of federal agents devoted to the war on drugs– Illegal drugs: supply curve shifts left

2. Policy of drug education– Reduce demand for illegal drugs

– Left shift of demand curve


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D1

Policy 1: Interdiction

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Interdiction reduces the supply of drugs.

• Demand for drugs is inelastic: P rises proportionally more than Q falls.

Result: an increase in total spending on drugs, and in drug-related crime.

Price of Drugs

Quantity of Drugs

S1S2

P1

Q1

P2

Q2

new value of drug-related crime

initial value of drug-related crime



1. Increase the number of federal agents devoted to the war on drugs– Illegal drugs: supply curve shifts left

• Higher price and lower quantity

– Amount of drug-related crimes• Inelastic demand for drugs

• Higher drugs price: higher total revenue

• Increase drug-related crime


Policy 2: Education

39

Education reduces the demand for drugs.

• P and Q fall.

Result:A decrease in total spending on drugs, and in drug-related crime.

Price of Drugs

Quantity of Drugs

D1S

P1

Q1

D2

P2

Q2

initial value of drug-related crime

new value of drug-related crime



2. Policy of drug education– Reduce demand for illegal drugs

– Left shift of demand curve

– Lower quantity

– Lower price

– Reduce drug-related crime


Income Elasticity of Demand

– How much the quantity demanded of a good responds to a change in consumers’ income

– Percentage change in quantity demanded

– Divided by the percentage change in income

• Normal goods: income elasticity > 0

• Inferior goods: income elasticity < 0


Cross-Price Elasticity of Demand

– How much the Qd of one good responds to a change in the price of another good

– Percentage change in Qd of the first good

– Divided by the percentage change in price of the second good

• Substitutes: cross-price elasticity > 0

• Complements: cross-price elasticity < 0


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The Price Elasticity of Supply

– How much the quantity supplied of a good responds to a change in the price of that good

– Percentage change in quantity supplied

– Divided by the percentage change in price

• Loosely speaking, it measures sellers’price-sensitivity


Q2

Calculating Price Elasticity of Supply

Price elasticity of supply

Again, we use the midpoint method to compute the percentage changes.

44

P

Q

S

P2

Q1

P1

P rises by 8%

Q rises by 16%


=Percentage change in Qs

Percentage change in P

The Variety of Supply Curves – 1

• Supply is unit elastic– Price elasticity of supply = 1

• Supply is elastic– Price elasticity of supply > 1

• Supply is inelastic– Price elasticity of supply < 1


The Variety of Supply Curves – 2

• Supply is perfectly inelastic– Price elasticity of supply = 0

– Supply curve is vertical

• Supply is perfectly elastic– Price elasticity of supply = infinity

– Supply curve is horizontal

• The flatter the supply curve– The greater the price elasticity of supply


S

Perfectly Inelastic Supply

• S curve:

vertical

• Sellers’ price sensitivity:

none

• Elasticity:

0

47

P

QQ1

P1

P2

Q changes by 0%

0%

10%= 0

Price elasticity of supply =

% change in Q

% change in P=

P rises by 10%


S

Inelastic Supply

• S curve:

relatively steep


relatively low

• Elasticity:

< 1

48

P

QQ1

P1

Q2

P2

Q rises less than 10%

< 10%

10%< 1


% change in Q

% change in P=

P rises by 10%


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S

Unit Elastic Supply

• S curve:

intermediate slope


intermediate

• Elasticity:

= 1

49

P

QQ1

P1

Q2

P2

Q rises by 10%

10%

10%= 1Price elasticity

of supply =% change in Q

% change in P=

P rises by 10%


S

Elastic Supply

• S curve:

relatively flat


relatively high

• Elasticity:

> 1

50

P

QQ1

P1

Q2

P2

Q rises more than 10%

> 10%

10%> 1Price elasticity

of supply =% change in Q

% change in P=

P rises by 10%


S

Perfectly Elastic Supply

• S curve:

horizontal


extreme

• Elasticity:

infinity

51

P

Q

P1

Q1

P changes by 0%

Q changes by any %

any %

0%= infinity


% change in Q

% change in P=

Q2

P2 =


The Determinants of Supply Elasticity

• Greater price elasticity of supply– The more easily sellers can change the

quantity they produce

• Price elasticity of supply is greater in the long run than in the short run– In the long run: firms can build new factories,

or new firms may be able to enter the market


Active Learning 3: Elasticity and Changes in Equilibrium

Assume the supply of residential apartments is inelastic and the supply of pork is elastic. Suppose population growth causes demand for both goods to double (at each price, Qd doubles).

• For which product will P change the most?

• For which product will Q change the most?

A. Draw a graph with the new equilibrium in the market for housing

B. Draw a graph with the new equilibrium in the market for pork



S

Active Learning 3A. Residential Apartments

54

When supply is inelastic, an increase in demand has a bigger impact on price than on quantity.

Residential Apartments (inelastic supply):

P

Q

D1

Q1

P1A

D2

B

Q2

P2


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S

Active Learning 3B. Pork

55

When supply is elastic, an increase in demand has a bigger impact on quantity than on price.

Pork

(elastic supply):P

Q

D1

Q1

P1A

D2

Q2

P2B


How the Price Elasticity of Supply Can Vary

56

• Supply often becomes less elastic as Q rises, due to capacity limits.

Price

Quantity 0

$15

12

Supply

100 525500200

43

Elasticity is small(less than 1).

Elasticity is large(greater than 1).


More Applications – 1

1. Can Good News for Farming Be Bad News for Farmers?

– New hybrid of wheat: 20% increased production per acre • Supply curve shifts to the right

• Higher quantity and lower price

• Demand is inelastic: total revenue falls

• Total profit falls if per acre cost is the same

– Paradox of public policy: induce farmers not to plant crops


An increase in supply in the market for wheat

58

S1

S2

Price ofWheat

Quantity of Wheat0 110

$3

2

100

Demand

1. When demand is inelastic,an increase in supply . . .

2. … leadsto a large fall in price. . .

3. … and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220.


More Applications – 2

2. Why Did OPEC Fail to Keep the Price of Oil High?

– Increase in prices 1973-1974, 1971-1981

– Short-run: supply and demand are inelastic• Decrease in supply: large increase in price

– Long-run: supply and demand are elastic• Decrease in supply: small increase in price


A Reduction in Supply in the World Market for Oil

60

Price Price

Demand

P2

(a) The Oil Market in the Short Run

Demand

(b) The Oil Market in the Long Run

S1S2

P1

1. In the short run, when supply and demand are inelastic, a shift in supply. . .

2. … leads to a large increase in price

P2

S1S2

P1

1. In the long run, when supply and demand are elastic, a shift in supply. . .

2. … leads to a small increase in price

Quantity 0 Quantity 0


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THINK-PAIR-SHAREIn order to reduce teen smoking, the

government places NT$20 per pack tax on cigarettes. After one month, the quantity demanded of cigarettes has been reduced only slightly. Discuss the following:

A. What conclusion can you draw about the one-month demand for cigarettes?

B. Caleb suggests that the cigarette industry should get together and raise the price of cigarettes further to increase total revenue.

C. Keisha suggests that only your firm should raise the price of your cigarettes to increase total revenue.



• The price elasticity of demand

– Measures how much the quantity demanded responds to changes in the price.

– Is the percentage change in quantity demanded divided by the percentage change in price.

– If < 1, inelastic demand: quantity demanded moves proportionately less than the price

– If > 1, elastic demand: quantity demanded moves proportionately more than the price

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CHAPTER IN A NUTSHELL


• Demand tends to be more elastic if

– Close substitutes are available

– The good is a luxury rather than a necessity

– The market is narrowly defined

– If buyers have substantial time to react to a price change.

• Total revenue (PxQ), total amount paid for a good

– Moves in the same direction as P (inelastic D)

– Moves in the opposite direction as P (elastic D)

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• The income elasticity of demand

– Measures how much the quantity demanded responds to changes in consumers’ income

• The cross-price elasticity of demand

– Measures how much the quantity demanded of one good responds to changes in the price of another good

• The tools of supply and demand can be applied to many different kinds of markets. This chapter uses them to analyze the market for wheat, the market for oil, and the market for illegal drugs.

64



• The price elasticity of supply – Measures how much the quantity supplied responds

to changes in the price.

– Is the percentage change in quantity supplied divided by the percentage change in price

– If < 1, inelastic supply: quantity supplied moves proportionately less than the price

– If > 1, elastic supply: quantity supplied moves proportionately more than the price

– Depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run.

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© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. Joseph Tao-yi Wang

Chapter 5: Elasticity

Different Types of Elasticities

Price Elasticity

Income Elasticity

Cross Price Elasticity

Homework:

Mankiw, Ch. 5, Problem 2, 7-12

Challenge Questions/ex-Midterm

2007 - Q2

2008 - Part D (+ Multi-Choice Q4-Q5)


10/5/2020

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Joseph Tao-yi Wang

Chapter 5: Challenge Questions/ex-Midterm 2009 - Part C5-C8 (+ Multiple Choice Q10)

2010 - (True/False Q4)

2012 - Part C (+ True/False Q5-6)

2013 - Part A3-A4, B (+ True/False Q4-5)

2014 - Part C1

2015 - Part B1-B3 (+ True/False A6)

2016 - Part A, B3-B4, F

2017 - Part B (except possibly B3)

2018 - Part A2-A4

2019 - Part A4-A10, C1-C4


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